In Technology, the Mother of All Price Wars

It's forcing hardware makers to rethink--or exit--the business

Michael S. Dell isn't blinking. Just as computer sales started to fall off a cliff back in September, the CEO of Dell Computer Corp. launched the meanest price war in the personal-computer business since George Bush Sr. was in the White House. So far, prices for PCs--and servers, too--have plunged by as much as 50%. With profit margins falling fast, Dell (DELL ) is taking its hit along with everyone else. But amid what looks to be one of the worst downturns in tech spending ever, Dell's chief figures he has the low-cost business model to tough it out and grab market share from weaker rivals--he wants to nearly triple his share of the computer business to 40%.

He just shouldn't bank on regaining those profit margins. In past tech downturns, the computer industry could price-slash its way to growth. Sure, profits shrank, but that was more than offset by huge swells in sales volumes as new customers were drawn in. Trouble is, the combination of a sluggish economy, mature markets, and more efficient products has taken the pop out of price wars. Today's price cuts are only marginally boosting sales--while completely eroding earnings. That means they're also setting the stage for longer-term problems, since prices and margins on hardware products rarely ever bounce back. "All Dell is accomplishing is to drain gross profit dollars out of the PC segment for everybody," says C.E. Unterberg, Towbin analyst James D. Poyner Jr.

Dell isn't the only one using that strategy as the tech slump slides into its eleventh month. From tiny silicon chips to powerful computer servers, no-holds-barred price wars fueled by oversupply and sluggish demand are raging in every corner of the hardware market. And it's not just old-line sectors that are suffering: Prices are plunging even in young markets ranging from handhelds to the network routers sold by the likes of Cisco Systems Inc. (CSCO ).

With sales and earnings getting hammered and demand still falling, the hardware landscape is likely to appear radically different when the smoke clears. Indeed, some business models that worked fine in the old environment of falling margins and rising sales are already faltering and will likely break. Computer makers will have to learn how to operate with ever-thinner profit margins. Or, as some are now doing, they'll have to look for related markets with fatter profit margins or drop out of businesses. "We're in for a round of consolidation, and only the fittest will survive," says Marc Jourlait, director of Hewlett-Packard Co.'s network-server business.

A prime example: storage systems, the washing machine-size gear used to house and sort reams of corporate data. Thanks to a battle to hang on to market share, the price of storage products from EMC (EMC ), IBM (IBM ), and Hitachi (HIT ) were down 24% in the first quarter, twice the historical rate of 12%, according to a recent McKinsey/Merrill Lynch study.

Things couldn't get much worse for the chip sector, either. With cell-phone sales flat and consumers turning up their noses at electronic gizmos, semiconductor sales are expected to tumble 21% this year, according to Merrill Lynch & Co. That has Intel Corp. (INTC ) and archrival Advanced Micro Devices Inc. (AMD ) locked in an increasingly costly price war. Even slashing prices 66% on some desktop-PC parts was not enough; on July 16, Intel whacked chip prices for laptop computers 37%, to $401.

NO SELL. The cuts are playing havoc with earnings. In early July, Dell rival Compaq Computer Corp. warned Wall Street that second-quarter earnings will come in sharply lower than estimates. On July 13, AMD reported earnings of $17.4 million for the quarter ended July 1--92% lower than the same quarter last year. Four days later, Intel matched that with an earnings plunge of 94%, to $196 million. Don't count on things easing up, either. Even as AMD CEO W.J. Sanders III vowed to analysts that "we will not lose market share" to Intel, its bigger rival also promised to be even more aggressive in pricing its core Pentium 4 chips.

Problem is, all those cuts aren't likely to do what they've done in the past--goose sales. Back in June, 1992, when the PC industry was well into its last big slowdown, Compaq lopped about 50% off its PC prices. It also released an entirely new line of low-cost computers that proved to be a hit. The following quarter, Compaq's revenue grew 50%, and the company began a surge that took it to No. 1 in worldwide PC unit sales. But that prize was costly: In 1993, Compaq's gross margin fell to 24% from 37% in 1991, and it hasn't been higher than 27.5% since. Even though Compaq's sales doubled from 1990 to 1993, pre-tax profits fell. The company earned $616 million on $7.2 billion in revenue in 1993. It earned $641 million on $3.6 billion in revenue in 1990.

This time, the formula isn't even benefiting sales, in part because the PC market has matured. Back then, the cuts helped draw many new customers into the PC market for the first time; today, 75% of buyers are replacing existing machines. And according to Merrill Lynch, unit sales of PCs worldwide are expected to decline 5% this year. Nor are firesale prices persuading customers to open their wallets--they've already binged on too many digital gadgets. "It used to be that you could cut prices and people would buy more," says Dataquest Gartner analyst Martin Reynolds. "There aren't customers for this stuff at any price."

Now, companies are struggling to figure out how to survive. In the short term, their options seem limited. They're laying off workers and squeezing more efficiencies out of supply chains while scrambling to fund innovations. And some are simply getting out of hard-hit businesses. On Mar. 23, Micron Electronics Inc. (MUEI ) dropped out of the PC business to focus on making memory chips. Then, on June 25, Compaq announced that it could no longer afford the cost of developing its proprietary Alpha chip technology and will shut the program down.

Longer term, further structural changes are inevitable as hardware companies adjust to permanently lowered margins. And that means another big downside throughout techdom: less money to invest in the operations of the business or to fund research and development, the soul of an industry that prides itself on innovation. With chip earnings so slim, for example, there's less to plow into next-generation plants or capital equipment--moves chipmakers have to take years in advance to be competitive.

Computer makers such as Gateway (GTW ), HP (HWP ), and Compaq (CPQ ) will also come under increasing pressure to change their business models--or come up with new ones. That will mean pushing additional services with their products or working with partners to off-load some of the costs. Last month, Compaq CEO Michael D. Capellas said that within the next four years, he wanted the company's higher-margin service revenues to grow from one-fifth of total sales to one-third. And on July 16, to bulk up service revenues, HP agreed to pay $610 million for the computer-services operation of Comdisco Inc. (CDO ), which had just filed for Chapter 11.

Even the strong will have to adjust. Dell is pushing into new, higher-margin markets, too. On July 18, the company announced that it will enter the network-switch business, another sign that it is seeking refuge from falling margins on PCs and servers.

Others are trying novel pricing schemes. IBM, HP, and Compaq are offering big-server customers a radically innovative utility-type system. Equipped with tracking meters, customers get monthly bills based on their usage instead of having to buy the server outright. While it's too early to tell how popular this will be, Compaq claims its new plan lowers a customer's total bill by up to 20%. For computer makers, the benefit is a steady revenue stream amid falling sales.

In the last downturn, Dell ended up figuring out a low-cost business model that turned the PC industry upside down. "The funny thing about the technology business," says Michael Nevens, a managing partner at McKinsey & Co., "is you never know when someone is going to come up with that `Aha!' product or business model." So far, no `Aha!' developments have emerged from this downturn. But if history is any guide, keep listening.

By Ira Sager, with Faith Keenan, in New York, Cliff Edwards in San Mateo, Andrew Park in Dallas, and bureau reports

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